No 7 on SOA Sample Questions & Solutions for Derivatives Markets

[arlbcd5612]

Hi, anyone finished the questions? I am confused by the No.7, at first thought, I selected the answer C (Prepaid forward contract). Then, I found the answer E is right (ie This arrangement is not possible due to arbitrage opportunities) too. We can borrow 100 at 6% to buy the stock, one year later, we get 110 from selling stock and return 100e^0.06 for borrowing, we get profit 110-100e^0.06.

[jraven]

At the time you actually enter into the contract you don't know what the future value of the stock will be, only that your ultimate profit will be S_1 - 100e^0.06. Since there is a risk that S_1 < 100e^0.06, this does not represent an arbitrage opportunity. That it ultimately turns out that S_1 = 110 is good for you, since you come out ahead, but irrelevant since you didn't know it would happen at the time you entered into the contract.

That said, the problem shouldn't really be making statements about the precise value of stocks in the future, what with the future not having happened yet and all. It gives the impression that the stock price is deterministic.

[arlbcd5612]

Thank you very much, Jraven. Your explain is crystal clear.